Monday, February 8, 2010

Questions about the coming wave of second mortgage writedowns

In the lead-up to the credit crisis, I really didn’t write a considerable amount about second mortgages despite my focus on credit writedowns. At that time, I was more focused on writedowns from securitized mortgage paper (and later construction loans and commercial real estate because of the stress these loan types put on regional financials). However, second liens are a very big deal and I believe they will loom that much larger in 2010 because of the rise in strategic defaults in prime and Alt-A categories.

When the crisis first developed, in February of 2007, it was subprime where the worries were, with the lion’s share of writedowns coming from mark-to-market losses in the securitisation market. However, subprime was a relatively small part of the overall market, making up 14% of loans outstanding at that time. Alt-A loans were 27% and prime loans were 57% respectively of loans outstanding according to a Banc of America Securities report.

As the 2004-2007 co-horts of Alt-A option ARM mortgages have started to reset and prime borrowers have come under stress, we have started to see defaults in markets which are an order of magnitude larger than subprime.

There are no specific numbers on how many option ARM loans there are. But analysts estimate that as many as 1.3 million borrowers took out $389 billion in option ARMs in 2004 and 2005 alone.

Many of those option ARM loans have already re-adjusted to higher payments, but more are on the way. Some 88 percent of Option ARMs originated between 2004 and 2007 are going to adjust higher between now and 2012. Those option ARM borrowers could see their housing bills go up as much as 63 percent, according to Fitch ratings.

The chosen solutions thus far has been to arrest the fall in house prices so that they are still at elevated levels. This is one reason the Fed is loath to raise interest rates; doing so would make interest payments unaffordable for many homebuyers and homeowners.

Nevertheless, the reset and strategic default issues are still with us and they bring second mortgages into view. I have been interested in the problem presented by second mortgages since I wrote a few posts on legal cases involving foreclosure, second mortgages and mortgage servicers.

What was clear then is that mortgage servicers were not incentivized to modify existing mortgages. The incentive for servicers is to service an existing mortgage for as long as they can in order to collect the fees associated with that servicing. The big four commercial banks are by far the largest servicers of loans. Here is the breakdown from an October post linked just below.

Bank of America: $2.1 trillion, up from $530 billion a year earlier (via its acquisition of Countrywide – this is WHY bank of America bought Countrywide)

Wells Fargo: $1.8 trillion, up from $1.5 trillion a year earlier

JPMorgan Chase: $1.5 trillion, up from $795 billion a year ago (thanks in large part to its acquisition of Washington Mutual)

CitiMortgage (a division of Citigroup): $792 billion, down from $799 billion a year earlier. Citi is hurting i everywhere)

ResCap: $391 billion, down from $449 billion in the first quarter of 2008.

But, as coincidence would have it, the big four commercial banks are at once the largest mortgage servicers and the largest second mortgage lenders. Here are the numbers from Amherst Securities’ Laurie Goodman via FT Alphaville.

The interesting bit is that, according to Reuters’ Felix Salmon, the lion’s share of writedowns on second liens to date come from that small sliver of ABS Issuers. The reason of course comes from the dichotomy between how loans and securities were treated before mark-to-market rules were liberalized last year.

You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not. This is one reason that large international institutions which participate in the securitisation markets have taken the lion’s share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets. But, this should end because of new guidelines in marked-to-market accounting. However, the new guidelines do have two major implications. First, there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses. Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses. In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment. If much of the impairment is real, as I believe it is, we are storing up problems for later.

So, when people default strategically, two things happen to the mortgage holder’s balance sheet. First, the losses become realized and must be accounted for. Second, the second mortgage gets vaporized.

I’m still trying to get to grips with the motivations of the too-big-to-fail banks given their outsized holdings of both second mortgages and service contracts and the lack of first mortgage holding. But, it seems that the interests of the servicer are to extend and pretend existing mortgages in order to get as much fee income as possible. So the Home Affordable Modification Plan (HAMP) isn’t going to be the preferred approach here and that’s why it is largely a failure.

But what about the second mortgage holder? They clearly don’t want a modification either because they are subordinated to the primary mortgage and must take all of the initial hit in a modification. So the government has set up a second lien modification program.

The Second Lien Program announced today will work in tandem with first lien modifications offered under the Home Affordable Modification Program to deliver a comprehensive affordability solution for struggling borrowers. Second mortgages can create significant challenges in helping borrowers avoid foreclosure, even when a first lien is modified. Up to 50 percent of at-risk mortgages have second liens, and many properties in foreclosure have more than one lien. Under the Second Lien Program, when a Home Affordable Modification is initiated on a first lien, servicers participating in the Second Lien Program will automatically reduce payments on the associated second lien according to a pre-set protocol. Alternatively, servicers will have the option to extinguish the second lien in return for a lump sum payment under a pre-set formula determined by Treasury, allowing servicers to target principal extinguishment to the borrowers where extinguishment is most appropriate.

Sounds pretty complicated if you asked me. As a large servicer who also has a lot of second liens, why would I agree to this if I could extend and pretend – especially since most modifications end up in foreclosure anyway? As I see it, the optimal response would be:

extend the loan and get as many payments as you can from the homeowner

meanwhile collect all the servicing fees in that time frame

at some juncture, this pretense comes to a close. So, avoid a foreclosure by inducing a short sale in which you (secretly?) get some compensation (see my post “Short sale fraud”).

That way if you end up getting a foreclosure anyway, you can get the most money out of the situation. Again, this assumes you don’t have any residual exposure to the primary mortgage since you securitized that. What am I missing here?

Your thoughts on this subject are appreciated. See also “This Crisis Won’t Stop Moving,” a recent article on second liens from the New York Times.